A Municipal Bond Cliffhanger

Municipal bonds are popular because the interest they pay is exempt from federal taxation. But in its search for solutions to the fiscal cliff, the US federal government is looking under every rock for more revenue sources. This could put muni bonds’ tax-exempt status at risk.

What effect could these changes have on investors? And what can they do about it?

Municipal bondholders have two possible paths to consider. As explained here, an increase in federal taxes would make the tax-exempt status of municipal bonds more attractive. This could drive yields lower and prices higher—boosting total returns.

Policymakers could take another route: they could limit the federal tax exemption on municipal bond income, reducing the attractiveness of muni bonds. President Obama has proposed a limit of 28% for all bonds, even those issued before the law was passed. The Bowles-Simpson commission proposed treating the exemption differently: it would completely eliminate it, but only for bonds issued after the law was passed.

It’s impossible to predict the outcome of the debate. Our hunch is that the muni-bond tax exemption is likely to remain on the books, but the benefit of tax exemption could be limited.

With the outcome far from certain, what should an investor do?

First of all, changes in the tax code would likely affect long-term bond prices the most, so it may make sense to reduce exposure to long-maturity bonds. Given the strong rally in long bonds, this would mean realizing a gain.

If the objective is to reduce risk from tax-law changes, investors should take their gains this year while long-term capital gains rates are still low. Furthermore, many investors might be able to apply these realized gains against tax losses from previous years, which may reduce the cost of taking the gains on long-term bonds today.

Second, managing volatility is important—no matter what taxes do. It might be wise to reinvest the proceeds from the sale into shorter-maturity bonds, which may mute the impact of any of the proposed rule changes, or even the potential impact of rising interest rates.

In the current environment, we believe that an intermediate-term muni portfolio (a moderate amount of interest-rate risk) and an overweight in lower-credit-quality bonds for added income may result in a less volatile portfolio and an attractive level of total return.

Most municipal investors prize stability. Today, there is a lot of uncertainty about the tax code. Municipal investors who are concerned about this uncertainty should consider reducing their holdings of long-maturity bonds.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Guy Davidson is Director of Municipal Investments at AllianceBernstein.